Sunday, July 16, 2017

Individual Investors Should Worry Professionals


When I became a professional securities analyst in the 1960s there was a trend to have two separate research and marketing efforts of brokerage firms. A traditional effort to serve individual investors was joined by a second, and higher paid effort to serve institutional investors. Around the cyclical movements of the stock market, individuals and institutions invested differently and each fed off the other's transactions. Institutions were able to buy what they thought were cheap stocks from supposedly unsophisticated individual owners and sell into them when individuals were not well enough informed. Interesting this dichotomy did not work to the disadvantage of the individual investors as much as it may have seemed. Individual investors were not only net buyers, but for the most part long-term investors that often facilitated the more rapid turnover of the so-called professional investors.

This relationship is no longer the case. Because of the decision of the US government to introduce price competition in brokerage commissions (which led to a price war) the profitability of directly serving the individual long-term investor declined meaningfully. Today try to get a “full service” retail brokerage representative to be interested in opening an account to handle the sporadic purchase of a hundred shares of a NYSE traded securities. If the broker can’t get the customer to open a margin account, buy new issues, trade over-the -counter securities or place decision making judgment in a managed account or a packaged product or possibly an automated relationship with a call center, chances are he/she will not be interested in the relationship with the perspective customer. Only the alternatives just suggested are profitable for the firm and the individual broker. Thus relatively few individuals are directly active in today’s stock market. They are investors through their employers’ defined contribution plans, land stock purchase plans, and or mutual funds/variable annuities or in some cases stock options.

The plain truth on most days, particularly in the summer months, almost all the transactions come through various institutional channels. The market has become largely a game of professionals competing against each other for research and trades. In some respects the market has become more susceptible to sudden volatility within the trading day as the professionals in this interconnected world react to each incremental research element and price change. Thus, a different sort of market analysis is required to avoid being at a competitive disadvantage.

The Players

Exchange-Traded Funds (ETFs), and Exchange Traded Notes (ETNs), while relative small in terms of assets as compared with other institutions,  are selectively quite large in the intra-day markets. While the regulators believed that when they permitted the creation of these vehicles in the US and a number of other markets, that individual investors would benefit from their low cost and trading efficiency, they really created trading vehicles for fast trading professional investors including hedge funds, market makers, managed accounts of investment advisors, central banks (Tokyo), and other institutional players.

In many weeks the aggregate net transactions in ETFs is larger than those of conventional mutual funds, even though their assets are less than half of the assets of mutual funds. While there are thousands of ETF transactions in a given week, the vast majority of transactions are in a couple of products that professionals are using to invest or hedge with or without margin type leverage. According to my old firm, Lipper, Inc., for the week ending Wednesday there was $6.7 Billion in net purchases of equity ETFs; $4.4 Billion went into PowerShares QQQ Trust EFI, invested in the 100 largest NASDAQ stocks, and $1.2 Billion into the iShares Core MSCI EAFE Index fund or about 5.65% of that fund’s total net assets. This left approximately $100 million for net purchases of all other equity ETFs.

A similar pattern was present on the taxable fixed income side which had total net purchases in the week of $1.2 Billion, with $1.1 Billion into two funds, iShares 20+Year Treasury Bond ETF, and iShares Core Total U.S. Bond Market ETF.

All four of these funds could be used to fulfill the short-term trading needs of institutions. To get a feel as to how important the trading is in these products, one should look at the extreme volatility of the major stock and bond indices in the last ten minutes of a trading day as the Authorized Participants (APs) try to even up their trading books. On some days in the last few minutes the stock indices can move close to 1/3 of the daily price moves for the whole day up to 3:30. Sometimes some of the transactions in ETFs are on the short side. In October of 2016 the size of the short interest was at a record level on the SPDR S&P500 ETF. Currently it is at the lowest level in more than a year. Obviously some trading institutions were shorting due to their views on the US Election. They may have viewed this as a hedge against some long positions or it could have not been paired against other holdings.

Mutual Funds are Evolving

There is also something happening in conventional mutual fund transactions. Despite a current period of relatively good fund performance, funds are experiencing net redemptions. A careful analysis will reveal that this is not a signal of disappointment. Most of the redemptions are coming out of the Large Cap Growth and Growth and Income funds that were the major receivers of decades of inflows driven by commissioned sales people. The basic investment pitch to potential owners of funds was to provide retirement capital and to a lesser degree educational funding. On an actuarial basis a good bit of these redemptions are completions fulfilling their intended purposes. In prior decades we would not have seen net redemptions because the normal completions would have been offset by new sales of funds, except selling funds to individuals is far less profitable than it has been in part because the sale freezes the money in place for a number of years due to anti-churning rules and commissions on funds are no longer the highest level available to the salesperson.

There is another important trend that takes mutual fund dollars out of the US marketplace. While domestic funds in the week had net redemptions of $4.6 Billion, non- domestic funds had net sales of $2.6 Billion. This is understandable on two levels. The Financial Times data shows that there are eighteen national stock markets it tracks. Eight had gains of between twenty and twenty-six percent and only one of these (NASDAQ) was in the US. The IMF is forecasting only India and China will have GDP gains of more than 5%.

Chart Readers

All three of the major US stock market indices, Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ composite started last week with a price upward gap. Often price gaps get filled before a major move occurs. In addition the NASDAQ composite daily price chart shows a reversal pattern called a “Head & Shoulders” which might be predicting a decline. As part of the market’s function to promote humility, this index is now rising near its former peak. The technical market analysts at Merrill Lynch stated that if the index breaks out on the upside it would be a failed Head & Shoulder pattern that is quite bullish. As usual there is an “on the other side” market research team at Charles Schwab that suggests that we should be prepared for a summer pull back.

Investment Conclusions

One of the reasons I came up with the TIMESPAN Lipper Portfolios® is to address this kind of situation, The second of the two portfolios, the Replenishment Portfolio, has a function of replenishing the Operating Portfolio which is designed to meet payment needs near term, or about  two years. The Replenishment Portfolio expects that over a market cycle it will be called to replenish the operating funds. This assumes that over a cycle (which typically takes four to seven years) there will be at least one down market. With this in mind Replenishment Portfolios should be examining their liquidity positions . This will be easier if they are in open end mutual funds that are not expected to “gate” or temporarily restrict redemptions in cash. In some cases large redemptions will be met with in-kind transfers. In most cases the transferred securities will be relatively easily sold.

The other two portfolios, Endowment and Legacy should not be disturbed. However if there was a serious decline one might want to switch. My data and consulting client, the late and great Sir John Templeton instructed to switch into better bargains when available.
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Sunday, July 9, 2017

Use Simple or Complex Mixes of Tactics and Strategies to Attain Investment Success.


The global stock markets are probably not priced with a lot of bargains. High quality, fixed income markets are full of fears. All markets including commodities and real estate are likely to be more volatile for the next couple of years than what we have recently experienced. If you disagree leave the worrying to the rest of us.

Our concern is based on the volatility that won’t be constrained and lead to panic-driven major disruptions. Since we don’t know what our next investment voyages will be like, we should examine our navigational tools. In our lives we know from our own or observed experiences that frequent changes rarely produce optimum results and in many cases deplete resources substantially. Thus the key to using the appropriate tools is the discipline to use them correctly and even when periodically they produce sub-optimum near-term results. Nevertheless there may be times when changing tools makes sense. Usually the best time to make switches is whenever a tool is too successful and not when it is underperforming. This reliance on intelligent discipline is one of the may lessons that I learned in the US Marine Corps.

Our basic four investment philosophical tools are:

1.   Reliance on Simplistic Approaches
2.   Recognition of Complexity
3.   Goal focused Strategies
4.   Timely Tactical moves


A study of most very successful individual investors appears to demonstrate that large wealth is generated by investing in ownership of equity, usually very concentrated to the point of a single investment.  It takes an unusual person that can tolerate the cyclicality involved in a single or even a highly concentrated portfolio. This cyclicality produces too much trauma for most. So they start to diversify. The problem with diversifying is that almost every day a new potential threat to one’s wealth shows up, particularly in the media. The standard risk control measure for new risks is to add some new protective investment. Over time this approach leads to a large number of investments.

In the modern world, people and institutions seek comfort in becoming part of the masses and either directly or indirectly index their portfolios. The thinking behind this is that all of these investors can’t be wrong, but equally they can’t be as right as the successful wealth-builders. Other simple philosophies are to only invest in highly credit rated stocks and bonds which produce similar upside and downside results. It is like someone who goes to the racetrack to bet on winning horses, so they bet on almost every horse in the race. Quite often they will have a winning ticket, but most of the time the money received will not pay for all the losing tickets. The nice part of simple moves is that they do not require additional thinking or analyzing.

Recognizing Complexity

There are no two people exactly alike. Even my twin grandsons, not only are they different, but they strive to be different. While each market has on the surface similar characteristics of prior market cycles, there are enough differences so the past is a bit instructive but not totally predictive. I believe that each portfolio and investor are different than others. One of the risks that some investors face in dealing with live managers and brokers as well as the so-called robo advisors is that at times one’s needs and preferences are not utilized in portfolios. One of the ways I recommend dealing with this is to divide an investment portfolio in terms of expected payouts. I start often with four timespan portfolios.

Each portfolio can be selective in terms of levels of aggressiveness/conservative as well as many other selection functions. Because consultants want to deliver the past to clients, they ask about the dispersion of performance within a manager’s book of business. To the extent that there is little dispersion, there is little attention as to the differences between people and institutions. All 401(k), pension plans, endowments, and families are different and deserved to be  treated that way. However, there is an expense to managing complexity. The difference is similar to buying off the rack versus custom produced and fitted clothes. Each has its place, but overtime the old rule of getting what you pay for generally works.

Goal Focused Strategies

Almost every physical and investment trip has bends and turns with occasional reversals. Those who successfully complete their trip do so because they have a navigational tool of an effective compass. We all understand that prices go down as well as up. While there are relatively few complete wipeouts, we have seen 90% declines in leveraged, highly speculative stocks in the 1960s and the 1930s. These are rarities. Most general stock market declines in a single generation are on the 50% variety. Within each rolling ten year period there is a 25% fall, and often within a ten year period there are three years of greater than 10% decline. Strategies should recognize the downside potentials, but also be aware and positioned for the upside.

Since 1926 the general stock market has on an annual basis gained in the range of 9%. We have experienced gains of three or four times the average and have seen a number of concentrated funds with speculative holdings post annual gains of over 100%.

Some may feel that because the number of publicly traded stocks is down by a factor of 50%, the institutionalization of trading, and the growth of index funds that past upsides will be curtailed. I would argue eventually the reverse. Periods of extreme concentration as we have been in, lead to lack of focus on securities that are not part of the highly valued concentrated portfolios particularly in the market capitalization weighted indices.

A very important point in assessing long-term investing is the power of reinvesting cash distributions (interest, dividends, and capital distributions). The great Sidney Homer, the long term head of Salomon Brothers fixed income research pointed out that for the long term bond investor there are three returns of cash over the life of the bond:  (a) proceeds from maturities, (b) current interest coupon payments, (c) and interest on interest.

Most people don’t fully appreciate that the third element produces the most cash. For example a bond with a 4% coupon held for a twenty year maturity will receive 100% of its issue price, 80% of its issue price for twenty years in interest payments, and if they can reinvest the interest payments at the same 4% for the period they will receive 119% of the issue price. The message here is that by buying and holding solid bonds and reinvesting the income, the return to the investor is larger than most believe. The key is not spending the interest and reinvesting it at a similar rate as the initial issue. (If you sense a certain rhythm to this approach it is worth noting Mr. Homer’s parents were both professional classical musicians.)

The interest on interest example is actually more powerful in investing dividend stocks and funds. Today they are many solid equity companies who are yielding 2% to 3% that over the next twenty years are likely to raise their current dividends at least at the rate of inflation, if not higher. Many of these stocks’ twenty year dividends will be higher than a 4% coupon on a high quality bond. Both many dividend paying stocks and all mutual funds have reinvestment mechanisms, so the equity investor does not have to look for current income opportunities the way the bond investor does. I am biased, but I believe the reinvestment potential through good mutual funds is better than many individual stocks. The US and UK regulators do not value the reinvestment mechanism in their assessment of the value to investors. Dividend paying stocks and mutual funds could represent a significant part of endowments and individuals long term portfolio segments.

Timely Tactical Moves

The first thing is to determine is whether the investor has trading skills. Can they recognize the difference between intra day and daily volatility vs. a meaningful change in price trends? There are some that believe that they posses this skill and a few may. It is very definitely an art form that requires the right personality approaches with extreme discipline.

Others attempt to be anticipatory and get ahead of new trends. As someone that has been known to be premature, too soon is often equivalent of being wrong. At times one may have to concede that one is premature and reposition for closer to fruition trends.

Contrarians can identify where they think the crowd is wrong and take a contrary view. Most of the time these moves don’t have much price risk as the market doesn’t believe in them.

My Dilemma

My dilemma is to find the correct communications with potential clients as to which of these tools should be used with all or a portion of their accounts. Any thoughts would be appreciated.
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Sunday, July 2, 2017

Janet Yellen Could be Right, If……


Janet Yellen, Chair of the US Federal Reserve Board of Governors, has said she does not expect a 2007-2009 financial crisis in her lifetime. For many reasons we hope that she has a long life. One of the lessons learned from lots of sports, including horse racing, and applied to business, portfolio management, and life in general is to be conscious of what could go wrong. If you will “the known unknowns” as well as making some allowance for “the unknown unknowns.” 

As an investment fiduciary I feel it is essential that one develops an appreciation for the odds that Ms. Yellen may be right.

What Causes Crises?

Major financial crises typically have both preliminary causes and a galvanizing event. The preliminary causes are relatively easily to spot, often by looking in a mirror. The event is often the unintended consequence to an action that forces many to brutally re-examine an intellectual or emotional structure in which we had total faith, that suddenly is found wanting.

Underlying Causes

The first cause is the belief in the inevitability of a pre-determined future. The growing enthusiasm for this belief overrides all past cautions. Because we all believe that we should be richer than we are, we will borrow to multiply our stake in the inevitable “goody.”  Often people and institutions look to borrow from any available source including surreptitiously from others without their notice... embezzlement. Thus, the essential second underlying cause for  crises is leverage. (For my mathematical readers- Enthusiasm in the “inevitable” times expanding use of “cheap” leverage = precursor of crisis.)

Where Are We Today?

Chair Yellen can not identify any major causes for concerns. She is right at the moment. Focusing on my continuing analysis of the global mutual fund business, I see some potential worries.

Are Equities About to Take Off?

One of the reasons that mutual fund performance is so often quoted by media, academics, and even government officials is that the data is quite accurate and rapidly and relatively available. I have been following these numbers for fifty years. This how I start to view the movements in the marketplace. On Friday we finished the first half of 2017. While the data is preliminary and subject to minor modification, it is instructive. There are at least nine investment objective averages producing double digit returns for the first half. (A copy of the list is available by contacting me. The leading investment objective is the Health & Biotechnology average of +18.46%)  Without dividends both the Dow Jones Industrial Average and the S&P500 were up 8% and using the Vanguard S&P 500 Index fund’s total reinvested return was 9.3% as a rough guide to the market.

In terms of our analysis, the key point: if the fund and general market performance produced high single digit gains in the first half, is it a reflection of growing enthusiasm which is relatively higher than the current sales, operating earnings, earnings per share or dividend growth? Remember that most institutions such as pensions and endowments have a targeted goal of between 4 and 9% for the year. The biggest gains were experienced by Growth rather than Value-oriented funds. Growth enthusiasts tend to be more future-oriented than value investors who are basically betting on correcting mis-priced securities. Either the markets are now premature in discounting future growth or will be in the future. Thus, we may begin to exhibit one of the standard precursr to a crisis.

Could Fixed Income be a Trigger?

The thirst for income is a global phenomenon to pay current or future bills. Almost everywhere that has a sizable Mutual Fund marketplace, money is pouring into bond funds at the retail level and into other credit instrument funds at the institutional level. What makes this concerning is the general market perception that interest rates will rise, and if things go wrong the rise could be significant. While Fixed Income investors typically focus on yields on purchase price, they are often shocked when they sell at prices below their initial purchase price. At some point at least the institutional investors will look at their investments on a total return basis incorporating current prices which could be materially lower due to interest rates rising. Future prices could be hurt by various trading entities like hedge funds being forced to meet collateral calls as their Fixed Income holdings are marked down to a declining market. My own suspicion is that the two segments which are most exposed to high leverage is government issued paper and credit instruments.

Archduke Accident Replay

Popular beliefs hold that World War I was begun as an outgrowth of the murder of the popular Archduke Franz Ferdinand of Austria on an automobile route in Sarajevo that had been changed due to security precautions from an incident earlier that day. The change was ordered without telling the chauffer.  The sad event set in motion countries that were already preparing for war and forced their allies to come to their aid. Often the trigger events are caused by an unintended consequence of a well intentioned act, often by some force within the government. Usually the forces that trigger the consequences have a much too narrow of a view of their impact. Allow me to suggest a hypothetical and probably improbable series of events.

Government officials and media pundits look at mutual funds as products with a sole goal of producing a higher return than some other measure. They fail to understand the history of the fund business. Mutual Funds started as a way to mobilize existing savings (usually on deposit) into long-term investing. To convince savers to part with some of their savings was not a simple exercise of giving the reluctant saver enjoying a level of security something to read. The sales process often took a number of sessions. The global fund business was a financial service activity not a financial product producer. Perhaps the key value of these financial services is not just the initial purchase, but subsequent purchases. Probably the greatest value during periods of scary market declines is urging the investor to stay invested. Finally, the process permits and encourages partial withdrawals and perhaps some switching into more appropriately aged investments. All of these services need to be available everyday and often in aggregate, cost more than the pure investment expenses. In recognition of these needs many fund distributors and allocators have styled themselves as wealth managers.

The UK’s Financial Conduct Authority is complaining that UK funds are not competitive enough. They want competition based on a single fee covering all the holder’s costs and performance. (They are not focusing that in many cases the services aspects of the fund business are equally or more important to the holder than fees and performance.) We have in the past seen similar naivety occasionally in the US. Some similar concerns had been expressed in the EU’s MiFid rules.

What Could Go Wrong?

For the moment assume that this type of thinking becomes popular in many countries, sales people and to some degree, service people will leave the fund business and migrate to more expensive products and services like hedge funds, private equity, venture capital, real estate, or “investment art.” There is some chance that the returns will be below mutual funds. Where this could create a large problem for various governments is that the growing retirement capital deficit is expanding and there will be pressure on taxpayers to fill the gap at the expense of other government services. Expanded government services will lead to higher inflation as the government will have to borrow more to pay its bills. Or taxes will rise which can in and of itself cause a financial crisis as taxpayers rapidly change their investing status.

What Are the Odds that Janet Yellen is Correct?

At the track regular horse players understand that in spite of all their considerable handicapping (analyzing) skills there is something called “racing luck.” Things happen that are the providence of the “unknown unknowns.” Ms. Yellen could luck out and there won’t be a financial crisis the rest of her life. 

For my responsibilities I am prepared to have to deal with some or more of these. I am growing particularly nervous over the next 18 months as governments that in general have a record of creating unintended impacts cope.  

Both the US and India are early in redefining their tax structure, France is going to attempt to become competitive through labor reform, China is restructuring economically and financially, and there is the little matter of Brexit.

One may need good advice now more than just faith that there won’t be any crises.        
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Copyright ©  2008 - 2017

A. Michael Lipper, CFA
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Contact author for limited redistribution permission.